The Roman philosopher Seneca wasn’t talking about the stock market when he wrote that “T...
How to Trade Technical Setups: Divergences
11/17/2015 7:00 am EST
There are numerous strategies that are used to trade the markets, and it's important to develop your own unique edge. Through my experience in helping clients manage the risks of trading, I have developed a system that has given me definitive signals with high risk-to-return ratios. This system involves looking for specific trade setups based on chart analysis and can be applied to any market. No system is flawless of course, but this gives you an idea of one approach that might help you decipher what's unfolding on the charts and how you might use that information to trade.
One of the main problems I think traders have is taking any trade signal they see and not waiting for the most ideal trade setup. You want a trade with a high risk-to-return ratio, either 3:1 or 4:1. With that goal in mind, you keep your losses manageable. Take the trade setups that are with the overall trend. This will increase the size of the move and increase the probability of a winning trade.
This setup will work on any time frame, but using a longer-term time frame will decrease the number of incorrect signals. I prefer to use a daily chart or a 240-minute chart with this approach, but these setups can be used for daytrading as well. You can use a one-minute, a five-minute, or a 15-minute chart to daytrade. The crude oil market is the only market where I use a one-minute chart.
I would recommend looking for the trade setups on a longer-term time frame until you learn what you are looking for. When daytrading, look for the most obvious and definitive trade setups. There will almost always be another setup throughout the day if you miss one. Also, you will see a lot of divergence setups on the one-minute and five-minute charts, so take the trades with the best risk-to-return ratio. If you have to put your stop too far away, the trade is not worth it as you could lose too much of your capital and not be able to take advantage of the next opportunity.
E-Mini S&P 500: 15-Minute Chart
What you are looking for is a divergence between the price and the stochastic, a momentum indicator. You want to see the price making a new high and the stochastic making a lower high. This is telling you that the market is making a false high, and indicating a good sell signal. This trade is with the overall trend and offers a high risk-to-return ratio. The chart below illustrates this concept in the E-mini S&P 500 futures.
Crude Oil: 240-Minute Chart
The next example is a 240-minute chart of crude oil futures. This trade set up very nicely. The divergence was very definitive and had two different probable entry points. As you can see, all you are looking for is the divergence and the chart formation to confirm the trade. The time frame does not matter. It all depends on what you are looking to risk on the trade.
NEXT: E-Mini S&P 500: Daily Chart |pagebreak|
E-Mini S&P 500: Daily Chart
This strategy can be used on any market, depending on which time frames you use. The next chart is a daily chart of the E-mini S&P 500. I have a 50-period and 100-day period exponential moving average, which represent solid support and resistance levels. When the market got to the 100-period moving average, you'll see a test and positive close on the day. This bar is what I call a pin bar (some call it a hammer bar; it resembles a "T" shape). The market went down, bounced off this 100-period average, and closed positive on the day. When I see this, I would recommend placing a long position on the close of the day, with a stop below the low on the bar. Again, trade with the trend and look for a high risk-to-return ratio.
This trade setup is not the most obvious setup, but you did get the divergence and the chart to confirm it. The risk is a little high on this trade, but if you monitor it daily, you can continually move up your stop. More importantly, the trade is against the trend, which results in less potential profit. The setup still works, but it is riskier to trade against the trend-especially when you are in the learning phase.
Euro and Yen: 15-Minute Chart
Following are two more examples, in the euro and in the yen futures, both using a 15-minute chart. I would recommend paper trading these setups until you get the hang of what you are looking for. As you know, nothing is guaranteed, so as you are learning, practice before you commit real capital, and work with a professional. When you see a setup, you are welcome to call me and ask if it is a valid setup, and how you might proceed with possible trading strategies.
This of course is just a brief overview of a technique I use to analyze market action. I would be more than happy to walk MoneyShow.com readers through some charts at the end of the trading day and identify trade setups. Learning will take some time, but stick with it!
By Dan Faretta of Lind-Waldock
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